Theory, Damned Theory and Dow Theory

11/28/00 09:10:04 AM

by David Penn

The September divergence between the Dow's industrial and transportation averages anticipated the October downturns.

Security: $INDU, $TRAN
Position: N/A

One of the biggest raps against Dow Theory is that the theory was developed during a time when the relationship between the industrial average and the transportation average was much more interdependent than it is today. Dow Theory suggests, among other things, that the price action of the Dow Jones Industrial Average must be confirmed by the price action of the Dow Jones Transportation Average. When a bearish divergence occurs, as it did in September 2000, Dow Theorists begin to anticipate weakness in the industrial average.

The thinking behind this theory is sound enough. As economies expand and industrial production grows, the transportation economy likewise grows as goods and services are delivered to consumers, and business-to-business exchange increases. When economies begin to contract, shipping needs also contract, and this effect can be clearly seen in the falling prices of transportation stocks. Because the transportation industry often begins to decline in advance of declines in the industrial economy, the transportation markets can be used in some contexts as a leading or cyclical indicator for the rest of the economy.

"The Averages Must Confirm" is one of the tenets of Dow Theory, which anticipates market weakness when the industrial and transportation averages do not move together. The divergence in the month of August between the two averages shown here served as a warning of declines ahead.

Graphic provided by: Yahoo! Finance.

For the first several months of 2000, the Dow Jones Industrial Average ($INDU) and the Dow Jones Transportation Average ($TRAN) moved more or less in tandem. Both averages peaked in mid-January, troughed in early March, and recovered in April. During the summer months, both averages oscillated in fairly narrow trading ranges. So far so good. However, in August, the Dow Jones Transportation Average began declining sharply and, by September, the transportation average had lost almost 7% of its value. Over the same time period, the DJIA actually advanced 7%. For the Dow Theorist, this is when the warning bells likely sounded. A divergence in which the transportation average is going down while the industrial average goes up signals bearish times ahead for the industrials. This time, Dow Theory did not disappoint.

By the beginning of October, the transportation average had lost an additional 7%. The DJIA, at the same time, spent September giving up about 4%. But further declines were yet to come. The transportation average went on to lose 6% in the first half of October before rallying in the second half of the month. The industrials shed an additional 11% in October's opening weeks before they too recovered by month's end. The total decline from point of divergence in August (the point at which the transportation average began to retreat while the industrial average climbed) to trough in mid-October was just under 10% for the industrials. The transportation average declined more than 16%.

A part of the case against Dow Theory suggests that the components of the transportation average do not have the same relationship with the components of the industrial average as was once the case. This is based largely on the dominance of railroads and railroad stock in both the transportation average and in the economy in past decades. (In fact, the transportation average was called the "railroad" average when Dow Theory was first developed.) However, while railroads still make up a part of the transportation average (for example, Burlington Northern and Norfolk Southern), a greater share of the transportation average consists of companies like FedEx and Airborne Freight, as well as airlines like Delta, Southwest, Northwest and US Airways. While the contemporary Dow Jones Transportation Average may not have quite the intimate relationship with the industrials that existed when Dow Theory was conceived near the beginning of the last century, it remains true that produced goods and services still need to be delivered. And when delivery begins to grow slack, can production be far behind?

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Theory, Damned Theory and Dow Theory

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